The energy industry is a dynamic sector that is constantly influenced by a multitude of internal and external factors, including gas prices, technological advancement, and asset diversification. Understanding the key value drivers within the energy industry can position businesses to capitalize on emerging opportunities, adapt to market fluctuations, and make informed strategic decisions.

Oil and Gas Prices, Market Conditions, and OPEC Actions

The energy industry is highly sensitive to market conditions, especially oil and gas prices. These prices are notoriously volatile, due primarily to their dependence on supply and demand dynamics. Several external factors contribute to this volatility, including political events and conflicts, as well as the actions of organizations like OPEC (Organization of the Petroleum Exporting Countries).

Understanding these market conditions is crucial for valuation, as they directly affect the financial performance of energy assets and companies. When oil prices are high and demand is robust, valuations tend to be more favorable. Conversely, during periods of low prices, due to oversupply or economic downturns, valuations may suffer.

Recent events showcase the complexity and fragility of oil and gas prices. The Russia-Ukraine conflict, for instance, triggered a significant upheaval in these prices. Between February and May 2022, oil prices surged by approximately 25%, while natural gas prices witnessed an astonishing 88% spike, from February to August of the same year. Russia — as one of the world’s leading crude oil producers — cast a shadow of uncertainty over global supply and demand dynamics. To counter recession fears and declining oil values, OPEC+ took the proactive step of announcing production cuts in October 2022, with the aim of shoring up oil prices.

Yet these efforts were further complicated by regulatory changes initiated in 2021, as these imposed stringent restrictions on oil and gas projects within the United States. These measures included the cancellation of the Keystone XL pipeline and the suspension of oil and gas leases on federal lands.

Understanding Price Differentials

Geographical location is a pivotal factor that affects both price differentials, or premiums, and operational efficiencies in the energy industry. Proximity to key infrastructure — such as pipelines, LNG terminals, refineries, and saltwater disposal facilities — can significantly impact the economics of energy projects.

Certain regions, like the Eagle Ford shale, the Permian basin, or the Haynesville shale, are strategically positioned for exporting and refining operations. These areas often experience lower transportation costs and in many cases benefit from established infrastructure networks and have differentials or premiums that affect the oil and gas prices in our valuations.

Additionally, seasonality impacts the value of assets, especially in particular regions (e.g., the Rockies). Premiums are reaped during the winter when natural gas is in high demand in the West, giving the Rockies a competitive edge over other gas-producing areas. However, differentials come into play during the summer, as premiums take a dip tied to shifts in supply and demand.

Reduction of Costs Through Consistency in Unconventional Resources

In recent years, unconventional resources — in contrast to their conventional counterparts — have risen to prominence as a dominant source of oil and gas production. While conventional resources are typically found in porous, easily accessible reservoirs, unconventional resources reside in dense, rock-like formations that are more challenging to access.

Consistency in results from unconventional wells is a critical driver of value, as past well performance can reasonably inform future projections. The ability to extract predictable, consistent results also becomes extremely valuable.

Consider the Permian basin and Marcellus shale, two prolific regions for unconventional resource extraction. The key to reducing capital expenditures and enhancing operational processes lies in the ability to learn from past experiences. Companies operating in these areas have leveraged their data to fine-tune well designs, optimize horizontal drilling practices, and refine fracking techniques. These measures not only cut operational costs but also contribute to the development of best practices for future endeavors.

For instance, instead of drilling numerous individual vertical wells, operators in the Marcellus have shifted towards drilling fewer — but longer — horizontal wells that extend deep into the formation. This strategic shift significantly enhances cost-effectiveness and improves the break-even economics of the project.

In the realm of unconventional resources, where the production rate is highest in the initial years, continuous innovation and the ability to replicate successful outcomes are essential. Companies that achieve highly productive unconventional wells with reliable and consistent results are the ones positioned for superior financial performance and, ultimately, higher asset valuations.

Increase in Reserves Through Technological Advancements

One of the core value drivers in the energy industry is the ability to increase proven reserves. Enhanced recovery techniques and advancements in technology play a crucial role in achieving this goal.

The recovery factor, or the percentage of oil and gas that can be extracted from a reservoir, can be significantly improved through technological innovations. Whether in conventional or unconventional assets, implementing new methods, such as CO2 injection or waterflooding, can boost recovery rates from an initial estimate of 60% to as high as 80% in conventional assets. For unconventional assets, we are seeing optimal proppant types and amounts, fluid types and amounts, and completion practices.

Valuations must account for these technological advancements when assessing the value of energy assets. Companies that invest in innovative recovery methods can unlock substantial value by increasing their proven reserves.

Integration Into Related Industries

To maximize value and mitigate risks, many energy companies are embracing integration and diversification into related industries. Rather than focusing solely on upstream exploration and production, companies are expanding into midstream operations, LNG (liquefied natural gas) ventures, saltwater disposal, and even water treatment facilities.

This integrated approach allows companies to reduce reliance on third-party contractors, enhance operational efficiency, and capture additional revenue streams. For example, owning midstream assets enables better control over transportation and distribution, reducing costs, and improving supply chain management.

Large energy corporations, such as bp and Chevron, have successfully integrated their portfolios to include various segments of the energy value chain, from extraction to delivery. These strategic moves enable them to adapt to changing market conditions and deliver sustained value to their stakeholders.

Asset Diversification and Hedging Strategy

Companies are increasingly recognizing the importance of spreading their assets across various regions, to mitigate risks associated with localized fluctuations in supply and demand. This diversification strategy offers a buffer against unforeseen disruptions, such as geopolitical conflicts or environmental regulations, which can severely impact energy markets. Companies are increasingly moving away from pure play strategies, building portfolios of oil and gas assets in different basins.

They are also actively incorporating hedging into their strategy, in weathering storms of price volatility, shielding them from potential losses when prices drop. Hedges are more than mere risk mitigators but hold the promise of long-term financial returns. Additionally, hedging allows companies to reduce uncertainty in prices and forecast them more reliably, allowing for more informed decisions on debt payment, development of current assets, and growth.

Capital Discipline Due to Cash Flows Versus Focusing on Production

Companies are also driving value through capital discipline. Traditionally, energy companies adhered to a production-centric approach, especially during periods of low prices. When faced with unfavorable market conditions, such as plummeting oil prices, their strategy often involved holding back on capital investments and refraining from expanding drilling operations. Instead, the emphasis was on optimizing production, particularly through the development of Proved Developed Producing reserves (PDPs).

However, a paradigm shift has emerged in the past four years, catalyzed by external factors like the Covid-19 pandemic and stricter government regulations. This shift revolves around a concept known as capital efficiency: prioritizing cash flow over sheer production volume.

Capital efficiency represents a strategic pivot, wherein a significant portion of company cash flows is directed toward shareholders, rather than being channeled into rapid drilling expansion. The primary objective is to maintain a consistent stream of cash flows, irrespective of market fluctuations. This not only minimizes risk exposure but also enhances the industry’s appeal to private equity investors seeking stability and steady returns.

The Value of Third-Party Valuations

Valuation firms specializing in the energy industry must navigate a complex landscape shaped by market conditions, technological advancements, geographic considerations, and strategic diversification. By understanding and effectively incorporating these key value drivers, they can provide accurate and valuable insights to clients in this ever-evolving sector. When searching for a firm, a valuation partner should bring extensive experience within the oil and gas industry and present expertise in the relevant business dynamics.

This article was originally published in World Oil.